When a bank concludes a transaction, it assumes an obligation whose value will change – increase or shrink – throughout its duration. The answer to the query
‘By how much?’ is never known in advance. This rise or fall in value due to price volatility reflects itself, correspondingly, into unrealized but recognized profits
OWN FUNDS RATIO
PROFITABILITY ACCOUNTING PRACTICES
TURNOVER OF ACCOUNTS (IN DAYS)
CASH FLOW
NET RECEIPTS RATIO COMPANY 1
COMPANY 2
COMPANY 3
COMPANY 4
Figure 15.2 A radar chart for crucial variables distinguishing whether a loan is eligible or ineli- gible for central bank refinancing
and losses – the IAS 39 and US GAAP stuff. It also tells a lot about market risk;
but there is also credit risk:
● If the transaction becomes more valuable, counterparty risk will grow.
● If the value of the transaction falls, counterparty risk decreases although market risk increases.
There are also other characteristics of inventoried positions which need watch- ing, each with its own criteria. Long and short positions are an example. The term longis used to describe a producer, trader or investor who has an actual commodity position. Short describes people and companies who have an obli- gation to deliver the commodity but do not own it. Hence, they will have to bor- row it, or buy it at a later date.
The virtual balance sheet, virtual income statement, and interactive computa- tional finance at large, permit the manager and the professional to keep steady watch intraday over recognized but not realized gains and losses. Enhanced through expert systems, this can be a most rewarding experience.
● With every transaction there is one or more crucial parameter(s) whose behaviour must be studied, to be ahead of the curve.
● Globalized markets don’t permit easy-going approaches and seat-of-the- pants judgement; and they penalize delayed response to ongoing events.
For instance, with derivatives at any point in time a crucial parameter is the underlier’s market behaviour which dictates the value of a position in the port- folio, and therefore the associated exposure. Another critical parameter is matu- rity. Other things being equal, longer maturities increase the likelihood that a certain price, rate, or market will move. This translates into position risk, on which the executive with responsibility must be immediately informed.
Moreover, the wave of change taking place in the banking industry is not con- nected strictly to derivative financial instruments, even if derivatives have been the vector that brought about a major transition. Also, in the traditional banking business, mainly lending and deposits funding must now face new and complex requirements in the management of embedded interest rate risk. Take as an example position risk in the loans book.
Whether the object of lending is customer needs, mortgages, or the wholesale markets, banks now must account for risks well beyond the well-known credit exposure and 1-year horizon. They must look at their P&L in a more sophisticated
way than the simple cost-of-money basis and assume at least a medium-term per- spective. Three risks are outstanding in connection to lending:
● Credit risk regarding the borrower’s trustworthiness, expressed in his or her ability to pay the interest and repay the loan.
● Interest rate risk, associated to fixed rate loans, and including mismatch risk which addresses the difference between the interest rate structure of deposits (or bought money) and that of loans.
● Liquidity risk, which arises when there is a difference in the maturity pro- files of assets and liabilities – particularly of current assets and current liabilities.
Each one of these risks must be thoroughly studied in all its aspects. Interest rate risk in the loans book provides an example. Simulation must include interest rates rising, falling, or steadily holding high or low for an extended time period.
Every one of these patterns has an aftermath, and senior management must be:
● Aware of the underlying reason, and
● Sure of its after-effect on the bank’s portfolio.
Interest rate risk and liquidity risk are embedded in the bank’s loan book, thereby introducing into it market risk. This market risk component is not too different from the one existing in the bank’s trading book which addresses the deals the institution makes in equities, bonds, and derivatives.
For better risk control reasons, many credit institutions today make internal inter- est rate swaps to take interest rate risk out of the banking book, bringing it to the trading book and hedging it. This process, however, is dynamic and the executive in charge of position risk must be fully aware of the impact of intraday changes on interest rates and on market liquidity. Left unwatched, both factors can cause a loss.
● Banking book exposures are typically more long term
● Trading book exposures are shorter term, with positions taken for resale and quick profits.
The virtual balance sheet and virtual P&L statement should reflect changes in the aforementioned risk factors as they happen, intraday. Simulators and expert sys- tems should be available to enable responsible executives to study and analyse the aftermath of hedging or repositioning decisions, prior to reaching them.
Until securitization became a driving force in the retail banking market, particu- larly for mortgages, credit cards and other receivables, banks held their loans to
maturity. They did the same with the securities in their portfolio. But securiti- zation of retail banking receivables has been typically passed by the corporate loans book’s securitization, as well as by credit risk mitigation (CRM) by means of a growing pallet of credit derivatives.
Critics say, with reason, that whether we talk of credit risk mitigation, fixed/
flexible interest rate swaps, or any other derivative instrument, there is no assur- ance that the hedge will be perfect. Indeed, the most likely outcome is that it would be asymmetric, leaving the institution with a significant amount of expo- sure. This underlines the need to know much more about what is happening than just applying the mechanics of a CRM or interest rate swap.
Here is what the 75th Annual Report (2004–2005) of the Bank for International Settlements had to say on persistently low interest rates: ‘Several explanations for the low level of long-term rates were proffered. Deteriorating prospects for economic growth provided an explanation in the euro area, Japan, but not in the United States … Longer-term inflation expectations were exceptionally con- trolled, but real rates were down as well. Low volatility and reduced risk premi- ums were also in evidence, but mostly at the short end, leaving longer-term forward rates still unusually low. Other possible explanations included prospec- tive pension fund and accounting reforms, perceived by some market partici- pants as increasing the demand for long-dated assets, and the accumulation of US dollar assets by Asian authorities.’
The BIS Annual Report concluded that it is difficult to quantify the impact of these latter factors, in a way that is valid in the most general sense. On the other hand, each credit institution has its underlying assumption which it uses con- cerning both the amounts and timing of future cash flows and discount rates.
A virtual balance sheet should take note of idiosyncratic factors, because this is the way the bank’s senior management thinks.
A similar statement is valid about accounting for counterparty exposure.
Changes in credit quality of loans in the portfolio must be taken into account in determining fair values, even if the impact of credit risk is recognized separately by deducting the amount of the allowance for credit losses from both book val- ues and fair values. While some institutions say that this is not necessary, because fair value is market value, and the market has already embedded the aftermath of credit downgrades, there is always a time lag exploited by sharp operators and paid by the laggards.
7. Real-time access to satisfy new Basel directives: